When it comes to asset allocation, however, Ivy League endowments offer investors several key lessons. In fact, studies have shown1 that asset allocation policy is the primary determinant of performance for endowments — so when Ivy League endowments reveal that they are steering a meaningful amount of capital toward real estate, savvy investors should take note. Here we’ll explore why and to what extent Ivy League endowments are allocating to real estate, and what it means for individual investors.
Ivy League endowment investment performance
University endowments are designed to provide substantial levels of cash flow for the institution’s operating budget, generating funds to help pay for research, salaries, and financial aid. Endowments are also tasked with preserving purchasing power for future generations, which fosters a focus on growth of principal and increased future earnings. As such, the programs tend to have long investment horizons, large asset bases, and little reliance on market timing for generating returns.
In terms of results, nobody meets their mandate better than the Ivy League: Among a pool of more than 800 college and university endowments, the Ivy League reliably dominates the upper ranks2 for returns. The vast majority of Ivy League endowments have achieved annualized returns that outperform other U.S. colleges and universities over a ten-year period, and many have posted returns which beat traditionally balanced portfolio blends of stocks and bonds. Over a recent twenty-year period, the standout endowments of Harvard and Yale posted average annual returns of 11.5%, besting a 60/40 global equity/bond portfolio by a substantial 5.5 percentage points annually, according to research published by the Chartered Alternative Investment Analyst Association3.
The rationale behind allocating heavily to real estate
A meaningful portion of the strong returns generated by Ivy League endowments appears to stem from their sizable allocations to real estate. To understand why these funds allocate heavily to real estate, it’s helpful to step back and examine their broader views on alternative investments. For the past several decades, endowments have increasingly committed to diversifying their portfolios by channeling more dollars to alternative investments such as hedge funds, private equity, venture capital, and real estate.
At the heart of this evolution is modern portfolio theory, an asset allocation framework developed by Nobel Laureate Harry Markowitz and widely adopted by institutional investors. Modern portfolio theory posits that investors can improve the risk-adjusted returns of their portfolios by diversifying across multiple assets with varied correlations. It proposes that investors can identify an optimal asset allocation designed to generate an ideal balance of minimal risk versus maximum return. For many investors, the framework recommends a portfolio allocation of 10-20% to alternatives, including real estate.
Many endowments have taken this portfolio construction philosophy and pushed it even further. Within the Ivy League, Yale’s David Swensen is often credited for creating and popularizing the so-called endowment model, which advocates for a markedly higher allocation to alternative assets. The approach has paid off handsomely: Swensen earned the Yale endowment more than $20 billion in excess returns over a 20-year period4, and during the first 30 years of his leadership, the fund earned an average annual return of 12.5%5.
Under Swensen’s direction, Yale dramatically reduced the endowment’s exposure to U.S. securities by reallocating from traditional to alternative asset classes. In 1987, nearly 80% of the endowment was committed to U.S. stocks and bonds. In recent years, the program’s target allocations have called for less than 12% in domestic securities while diversifying assets such as foreign equity, real estate, and venture capital have come to dominate the endowment, representing nearly 90% of the target portfolio.
As a guest lecturer in a Yale economics class, Swensen highlighted his philosophy’s emphasis on asset allocation and diversification: “In terms of diversification, [the endowment portfolio has] half a dozen asset classes with weights that range between 4% and 28%. So, if you … took a look at that and compared it to 50% in domestic stocks, 40% in domestic bonds and cash, and 10% in a smattering of alternatives, you’d say that [the current portfolio] is really a much, much better diversified portfolio than the one with which we started.” Other endowments are following suit, with alternative assets in university funds rising from only 7% of holdings in 1990 to 55% in 20156.
Within the category of alternatives, real estate plays a vital role: Ivy League endowments commonly target high single-digit percentage allocations to direct real estate investments — and often much higher. For example, Yale’s average real estate allocation between 2013 and 2017 was 15.1%. Over the past twenty years, its real estate portfolio has generated an impressive 10.3% annual return, as noted in its 2017 report7. Beyond Yale, performance attribution tests8 show that private real estate exposure explains a meaningful 17% of the returns generated by Ivy League endowments between 1992 and 2013.
Ivy League investment programs are drawn to real estate’s potential to provide meaningful diversification alongside its ability to generate a steady flow of income with equity upside. Endowments also cite real estate’s ability to act as a natural hedge against unanticipated inflation. The University of Pennsylvania, for example, is clear about its evolving preference for allocating toward greater diversification and more inefficient markets, and the endowment’s recent report9 showed that its target allocation to real estate had increased several percentage points over the past decade.
What Ivy League endowment real estate allocations mean for accredited investors
Compared to Ivy League endowments and institutional investors in general, most individuals allocate substantially less of their portfolios to alternatives at large, and even less to real estate in particular. In fact, individuals dedicate an average of just 5% of their portfolios to alternatives, according to a report by the Money Management Institute. As a result, individuals with long-term investment horizons may be missing out on a potentially attractive source of diversification and risk-adjusted return.
It’s important to note that Ivy League endowments primarily focus their real estate capital on private, direct investments; publicly-traded real estate investments, such as shares of REITs, are less commonly held. While accredited investors may readily recognize direct real estate as a valuable addition to the traditional stock and bond portfolio model, it has historically been difficult to efficiently access the asset class. Ivy League endowments are able to draw on relationships and local expertise to identify quality investments, but it is often more challenging for individuals to complete the rigorous analysis required to add high-caliber direct real estate investments to their portfolios. Fortunately, the investment landscape for accredited investors is changing. Platforms like Cadre are enabling more efficient, institutional-calibre participation in direct real estate investments, allowing accredited investors to more closely apply the endowment model to their own portfolios.